Income Replacement Method

Before an adviser can size a retirement corpus, they have to answer a simpler question: how much income will this person need in retirement?

The income replacement method answers it from the income side. Take what the person earns now. Grow it to what they will be earning on the day they retire. Then keep a percentage of that figure.

That is all it is. No list of expenses, no guessing what groceries will cost in 2050.

The workbook is clear about the trade. The method is simple to follow and useful to set a savings target when retirement is some time away. But it is a rule of thumb, so it does not take individual circumstances into consideration. Assuming expenses will automatically fall in retirement, the workbook says, may be wrong.

Its sibling is the Expense Protection Method, which starts from expenses instead. Same goal, opposite direction.

Section 3.2.2 sets out five steps, and they are examined in order.

1. Calculate the current income.
2. Estimate the rate at which income is expected to grow over the years to retirement.
3. Calculate the years to retirement — retirement age minus current age.
4. Calculate the income at the time of retirement as current value x (1 + rate of growth) ^ years to retirement.
5. Apply the income replacement ratio to that figure.

Notice what step 4 is doing. It is compounding the income, not the savings. Salaries rise, so the income being replaced is the income at the end of the working life, not the income today. Skipping this step and applying the ratio to the current salary is the single largest error the method invites.

The replacement percentage in step 5 is where the workbook's judgement sits: usually 70 percent to 90 percent of pre-retirement income, but lower where a large part of that income was going into savings.

When to use it. In the early years of planning, when there is less clarity on future income, the workbook says it is more convenient to go with thumb rules. In the last 5 to 10 years before retirement, it is better to consider the particular situation of each individual instead.

What comes next. This method delivers the annual income required in retirement. That figure is then discounted over the years in retirement at the real rate of return to arrive at the retirement corpus — the calculation in section 3.2.7.

Income at retirement = Current income x (1 + rate of growth in income) ^ years to retirement

Income required in retirement = Income at retirement x income replacement ratio

The growth rate here is the rate at which income is expected to grow, which is not the same thing as the inflation rate used elsewhere in the chapter.

The workbook's own case. Pradeep earns Rs 10,00,000 a year. He is 30 and expects to retire at 55. He expects his income to grow at 10 percent a year and estimates he will need an income replacement of 75 percent.

The number that startles candidates is the Rs 1.08 crore. It is not a mistake. Twenty-five years of 10 percent salary growth multiplies an income by 10.83 times, and the method replaces a share of that — not a share of today's Rs 10 lakh.

See what happens if you skip step 4. Applying 75 percent to the current Rs 10,00,000 gives Rs 7,50,000 a year, against the correct Rs 81,26,029. The plan would then be built to fund about 9 percent of the income Pradeep actually needs.

And see how sensitive the answer is to the assumption. If his income grows at 8 percent instead of 10, the income at retirement is 10,00,000 x (1.08) ^ 25 = Rs 68,48,475, and 75 percent of it is Rs 51,36,356 a year — a difference of roughly Rs 30 lakh a year from two percentage points of assumed salary growth. That sensitivity is exactly why the workbook wants the plan reviewed as retirement approaches.

Chapter 3, section 3.2.2 (Determine Income Requirement in Retirement), presents the income replacement method and the expense protection method as a pair, each with a worked Pradeep example. Both are heavily examined and the paper likes to test them against each other.

Expect the five steps in order, the Pradeep computation itself, and a comparison question: the income replacement method is simple but ignores individual circumstances, while the Expense Protection Method is more accurate but cumbersome because of the detailed listing of post-retirement expenses it needs. A recurring conceptual question asks which method suits the early planning years (this one) and which suits the last 5 to 10 years before retirement (expense protection, or at least an individually set ratio).

• Grow the income first, then apply the ratio. Applying the replacement percentage to today's salary is the most common error, and it understates the requirement enormously.
• The growth rate is income growth, not inflation. The workbook uses 10 percent for Pradeep's salary growth; the inflation figure in the neighbouring expense example is 6 percent. Two different rates doing two different jobs.
• This method sizes the income, not the corpus. The corpus comes from discounting that income stream over the retirement period at the real rate of return, in section 3.2.7.
• It is a thumb rule, and the workbook says so. The stated weakness is that it takes no account of individual circumstances — in particular, assuming expenses will automatically go down in retirement may be erroneous.
• Years to retirement is retirement age minus current age — 25 for Pradeep, not 30 and not 55.
• Do not confuse the method with the income replacement ratio. The ratio is one input to the method; the method is the five-step procedure that uses it.